Butterfly Labs pioneered a key piece of hardware. So why are so many customers suing the company? We went to Kansas City to find out and spend some time with its secretive co-founder

UPDATE 9/23: The United States Marshals Service has raided Butterfly Labs’s headquarters and frozen the company’s funds. No arrests were made. The Federal Trade Commission also announced that it has filed a civil lawsuit against Butterfly Labs. They are attempting to shut down Butterfly Labs for good.

Jonathan Wagner should have been part of the bitcoin nouveau riche—a group of hundreds of early adopters that made millions off the booming cryptocurrency over the last couple of years. But he missed out on the surest money-making scheme since the Gold Rush, and for that, he blames a little-known company called Butterfly Labs.

Wagner, a soft-spoken software developer in his early 40s, was actually on the early end of the bitcoin movement. He read widely about the currency and was convinced the phenomenon was real. He decided he wanted in.

Back then, the obvious way to try to make money from the currency was to begin mining bitcoin. To do that, he needed a “rig,” just like gold diggers used pickaxes. In bitcoin, each transaction has to be “validated” before the currency can change hands, and it is the miners who handle that validation with their rigs. For doing that work—which requires a ton of energy, sort of like running five air conditioners at full blast—miners are rewarded with bitcoin, which can then be converted to cash.

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Bitcoin mining rigs range in size and form, but in their rawest form, they just look like giant servers with lots of wires. Here is Butterfly Labs' testing facility at its office in Leawood, Kansas.

When the price of bitcoin began its crazy, speculative ascent last year, Wagner and some buddies happened across Butterfly Labs, a little startup that sold bitcoin mining gear in Leawood, Kansas, not far from where Wagner lives with his wife. There wasn’t much out there about the company, but its founders were taking orders—along with the upfront payment for those orders—to finance the production of what they said would be the fastest, most energy-efficient rig yet. The prices ranged from a few hundred dollars to $29,899.

Wagner was skeptical about the company—no company had ever built a “bitcoin ASIC” miner like this before—so he sent a few friends to check out the company. Inside, they were greeted by a facilities manager and given a short tour. Despite some chatter online about the co-founder’s mysterious past, Wagner decided in April 2013 that the potential upsides were worth $650, the price of a lower-end model. If the price of bitcoin continued to skyrocket, even the company’s most basic rig could make them a ton of money.

Seven days after Wagner and his three friends bought their machine, BusinessWeek ran a story titled “Meet the Bitcoin Millionaires.”

April became May. May became June. June to July. Still, no miner arrived. The company announced delay after delay. In November, seven months after he ordered it, Butterfly Labs finally shipped the miner to Wagner and his friends. But by then, for reasons we’ll get into later on, it was pretty much too late.

These suits, taken together, suggest that for all the bitcoin winners we read about, there are perhaps more losers—and they're angry.

Butterfly Labs is now at the center of a storm of complaints from hundreds of angry customers who say the long delays in shipping the machines cost them their potential nest eggs. One of them, Martin Meissner, who lives in China, plunked down $62,000 on Butterfly Labs equipment in March 2013. He ended up suing the company for $5 million to $7.5 million for lost bitcoin revenue. Another plaintiff in California sued for similar damages earlier this year. (Both declined to comment, and Butterfly Labs says it will “defend ourselves vigorously” against Meissner’s claims.

Other disgruntled customers have joined a class-action lawsuit against Butterfly Labs, which sold up to $30 million worth of mining gear last year. The case is set to go to trial this summer.

Bitcoin has been one of the great business and economic stories of recent decades—there are many smart people who believe that the cryptocurrency could even replace the U.S. dollar one day. Even Marc Andreessen, one of Silicon Valley’s most prominent investors, has compared bitcoin to the Internet itself. “Bitcoin is in the early stages of mainstreaming today,” he said recently.

So far, it has been almost exclusively a bullish story of the stratospheric rise of the value of the currency over the last three years, and a once-pie-in-the-sky idea that clearly cracked the mainstream. If you needed any further proof of bitcoin’s growing appeal, you can now even book your next vacation on Expedia with bitcoin. Or use it to buy lunch.

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Eat fresh–with bitcoin.

But Butterfly Labs offers a taste of a darker side of bitcoin that is just starting to emerge. Butterfly Labs isn’t the only mining company being hauled into court. CoinTerra, a bitcoin mining hardware manufacturer based in Austin, Texas, faces a similar class-action lawsuit. And HashFast, a startup in San Francisco, has been accused of fraud.

These suits, taken together, suggest that for all the bitcoin winners we read about, there are perhaps more losers—and they’re angry.

***

As Butterfly Labs tries to convince customers and investors that the company is, in fact, innovative and reputable, it has another problem to contend with: its co-founder’s seriously checkered past.

Sonny Vleisides’ official Butterfly Labs biography is pretty circumspect about his background. It lists him as the company’s “innovation officer” and merely states that he “provides a wealth of experience in bringing new ideas to market.” What the bio doesn’t say is that Vleisides is also a convicted felon.

Until now, Vleisides, who is 43, has shied away from the press. But given the current lawsuit, the rampant speculation online about fraudulent activity (it’s not uncommon to see blog posts that say things like “Butterfly Labs aka BFL is probably the largest BTC scam to date”), Vleisides and his team have recently gone on the offensive to rehabilitate the company’s image.

They invited me out in late May, and I spent some time with Vleisides.

Vleisides’ professional career began in 1991, the year he dropped out of the University of Missouri Kansas City. The way he tells it, he was sitting in class one day when an overtly liberal professor starting pushing her personal views onto the students. College wasn’t for him.

So began a series of adventures abroad. He hopped on plane to Russia, where he intended to work with a film crew shooting a movie in Ukraine. The plan didn’t work out, but he stumbled into another endeavor: importing limousines from Florida to cater to Moscow’s wealthiest denizens. After Russia, Vleisides traveled through Europe, stopping in Greece for some time, but eventually made his way down to Costa Rica.

That’s when things got interesting. In Costa Rica, Vleisides got involved in planning something called the Laissez Faire City, a 100-square-mile tract of land that would have no government officials and would be entirely run by free-market individuals. The idea was taken straight from the pages of Ayn Rand:

Laissez Faire’s founders took out an advertisement in the Economist to promote the new city. People began sending in checks to buy plots of land. “Some of them have been sending us unsolicited money, which is more than we asked for,” Vleisides told the newspaper, which listed him as the “editor of the Laissez Faire City Times, the newsletter sent to every prospective founder.”

After 1995, there’s scant mentions of Laissez Faire City online, and it appears the project simply fizzled. (Vleisides chose not to comment about his involvement in Lasseiz Faire City for this story.)

But that wasn’t Vleisides’ only questionable venture. Over the next few years, while still living in Costa Rica, he started a software company called SportsBook Solutions that provided the digital backend for the newfangled world of online gambling. He ran the company into the early 2000s, right when online gambling was taking off.

But while traveling in Florence in 2007, he was picked up by Italian police and accused of running a “massive international lottery scam.” Prosecutors claimed that from 1990 until 2006, Vleisides, along with at least five other co-conspirators, sent out tens of thousands of mailings to victims in the United States, many of whom were elderly. The mailings advertised various lotteries and falsely promised participants a high likelihood of winning.

"I need to overcome the stigma of the conviction. I really do." —Sonny Vleisides

But, prosecutors claim, Vleisides and the other defendants never actually bought any lottery tickets. In total, participants lost “in excess of $19 million,” according to the affidavit.

While fighting extradition to the United States, Vleisides served nearly two years in an Italian prison. Eventually, he pled out, and upon re-entry to the United States, he was sentenced to time served and placed on probation.

When I met with him last month, Vleisides said he preferred not to talk about any of this. “I just don’t want to go there, in terms of disappointing anyone,” he tells me over sweet potato pie in his favorite BBQ joint just outside Kansas City.

“I’d like to think that everything that I’ve gone through, I’m going to go out there and show everybody how they can depend on me,” he says. “I could be a person they respect. I need to overcome the stigma of the conviction. I really do.”

***

On a muggy Wednesday morning, I arrived at Butterfly Labs offices, a 6,700-square-foot space that doubles as the company’s assembling facility. The building, situated in a commercial part of town, looks more like a scene from Office Space than a high-tech startup—it’s a quiet office, with people milling around. Murals of coaster-sized computer chips decorate the walls.

In person, Vleisides is charming and friendly as can be. He arrives for our meeting with a grin and wearing a blue polo. He has a Leave It to Beaver cowlick that complements his already-boyish features.

He’s eager to dive into the story of his startup. In 2009, Vleisides says he was beginning to work on an app for the automotive industry. The app would allow car dealers to share pricing information with each other on an encrypted network. Needing some assistance to develop the platform, Vleisides went into developer forums to find a partner. Eventually, he began chatting online with a man named Nasser Ghoseiri, a software developer living in Paris.

While the automotive app idea fizzled, the pair began chatting about new projects. In 2010, bitcoin really started gaining media attention, and Vleisides and Ghoseiri saw potential. “Bitcoin at the time was a silly little thing,” Vleisides says. “But I came from a libertarian background. I had been involved in digital currency projects in the past, so for me, this was really cool.” The company launched in 2011 with two people and no outside funding to speak of. It now has 40 employees.

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Brothers Cameron and Tyler Winklevoss, who gained fame for their portrayal in The Social Network, have started a fund to invest in bitcoin startups.

REUTERS/Lucas Jackson

To understand why bitcoin can be so lucrative, you first have to understand how bitcoin works. If Bill sends Mary one bitcoin, the transaction isn’t complete until miners run the requisite equations to validate that everything is legit. For doing this, miners receive small transaction fees, as well as coins earned from the completed block.

But as more miners enter the network—and as more bitcoins are mined—it becomes incrementally tougher to mine for bitcoin. Think of it like a gold mine: The deeper you go down, the harder and more expensive it gets to find gold. At some point, if the equipment you’re using to actually get the gold becomes more expensive itself than the gold itself, it doesn’t make sense to mine. In total, there are only 21 million bitcoin that exist, and about 12.8 million have been mined for so far.

There are those who claim (both in the lawsuit, and in various online forums) that Butterfly Labs was late with the deliveries because it was running a scam. They argue that the company decided to use the bitcoin mining equipment for itself, rather than ship to customers. The price of bitcoin was skyrocketing, the argument goes, and it became more lucrative to mine than to sell mining gear. The company strongly denies this claim, and, frankly, it has a whiff of conspiracy theory to it.

In June 2013, Ars Technica, the tech blog, used the miner "to make it (virtually) rain" money.

The more likely scenario is that company paid way more attention to advertising and getting orders than to the production part of the business.

Butterfly Labs, like other mining companies, took customer pre-order money for products that it had not yet manufactured. Think of it like Kickstarter: Customers give Random Entrepreneur X money, and that entrepreneur theoretically goes out and builds the product.

Had the company been taking money for an iPad stand, delays wouldn’t be such a big deal. But because the value of a bitcoin miner is directly tied to how quickly the manufacturer can ship it to customers, timing was key. And Butterfly Labs blew it, which means its customers blew it, too.

People like Martin Meissner sunk tens of thousands of dollars into these pieces of equipment, thinking they’d arrive and he could quickly enjoy the windfall of bitcoin mania. Other purchasers chose to invest their life savings into these bitcoin rigs. “Me and my family are distraught and $30,487 out of pocket,” one Butterfly Labs customer wrote. “This is the last hope I have left.”

For all the controversy that surrounds Butterfly Labs, those who have gotten to try out the rigs have been impressed. In June 2013, Ars Technica, the tech blog, used the miner “to make it (virtually) rain” money. Another Google review claims it’s one of the “best ASIC miners on the market.” The only drawback? “Bottom line is this company makes it very clear NOT TO PURCHASE their pre-ordered products if you’re not willing to wait.”

You could rightfully argue that customers should have been a little more wary about plunking down thousands of dollars in pe-order money on products that didn’t exist yet. The company won’t discuss its strategy for the upcoming trial, but Butterfly Labs—and the other mining companies facing litigation—will more than likely argue that they made no promises about specific delivery dates.

***

Butterfly Labs says things are beginning to look up again. According to Vleisides, the company has now made good on all of its outstanding shipments. Even Wagner, though disappointed by the delay, has received the miner and is impressed with its quality.

Butterfly Labs is also in the final stages of developing a physical bitcoin wallet, a cool business-card-sized device that’s capable of storing all your bitcoins.

This time around, the company has decided not to charge customers for the product until it’s actually built.